A new academic study adds yet further proof to the growing mountain of evidence that “active management” is largely a myth, at least among hedge fund managers. Mikhail Tupitsyn and Paul Lajbcygier of Monash University in Australia highlight that not only are two out of three hedge fund managers actually “passive” in their investing approach, even those that are active managers at first tend to become passive over time.
The authors also point out that passive managers tend to outperform active managers, especially over the long run.
Most hedge fund managers are passive investors
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Tupitsyn and Lajbcygier begin their paper by noting that earlier research has “challenged the notion of hedge fund managers possessing skill (Fung and Hsieh 1997; Hasanhodzic and Lo 2007), suggesting instead that they extract a significant part of their returns from “passive” linear systematic risk exposures.”
The use of generalized additive models to explore hedge fund returns allowed the researchers improved insights into the kinds of investments hedge funds are actually making. Their first conclusion is that when hedge funds are analyzed based on style of portfolios, “nonlinear risk exposures are more pronounced in styles that focus on exploiting arbitrage opportunities and relative security mispricing, consistent with findings of Mitchell and Pulvino (2001), Fung and Hsieh (2002b), and Agarwal and Naik (2004).”
Tupitsyn and Lajbcygier also examined nonlinear patterns in risk exposures of individual hedge funds using GAMs, and found that more than two-thirds of portfolios only have linear exposures. Moreover, nonlinear features are only found in the exposures of around one-fifth of funds, the remainder of funds have insignificant exposures to any systematic risk factors and are in effect “market-neutral funds”.
To optimally evaluate the impact of nonlinear risk exposures on hedge fund performance, the two researchers built three portfolios of funds for each style: a portfolio of only linear exposed funds, another portfolio of nonlinear funds and a third portfolio of market-neutral funds. The results indicate that nonlinear funds on average underperform linear funds in terms of raw and risk-adjusted returns and also suffer from higher negative tail risk. The authors note “this provides evidence against hedge fund managers’ claims of skill leading to superior returns.”
The pair also examined the persistence of hedge funds to risk exposures to prove whether performance patterns seen in nonlinear, linear and market-neutral funds can be used to produce profits. Their conclusion was that the majority of nonlinear hedge funds that operate over a longer term change their risk exposures over time to eventually morph into linear funds.
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